(originally published at shadowbankers.wordpress.com on May 26th, 2009)

Another week passes…and another quiet, yet strategic announcement by China regarding the future of the Yuan. It was announced early this week that HSBC and the Bank of East Asia in Hong Kong would be the first foreign banks given the authority to issue debt denominated in Chinese Yuan. After their numerous announcements regarding bilateral currency swaps,Chinese officials have taken an even greater step towards pushing the Yuan towards eventual reserve currency status.

However Michelle Bachmann shouldn’t be panicking just yet, and remain focused on connecting swine flu to the Democratic Party, as we still have a ways to go before the Yuan can function as a reserve currency in any tangible manner. What China appears to be doing is simply increasing the liquidity of the Yuan in a very focused, regional manner. The usage of Yuan has been increasing at the level of the ‘man on the street’ as it’s slowly becoming more common that stores in Hong Kong are accepting Yuan for purchases. This is still limited by local residents only being able to purchase 20,000 Yuan per day with their Hong Kong dollars (yes, that’s nearly $3,000, but they do love their luxury goods). The announcement of offshore debt being issued in Yuan will now allow for the transacting of Yuan by the multibillion dollar pension fund. The end goal is whether its a local buying a $10 shirt or Bill Gross buying a billion dollar bond issuance, the purchase will take place in Chinese Yuan.

Why do they want this? As the frequency of Yuan Bonds circulating increases, so does the acceptance of the currency as a basis for business. The government of China will slowly be able to issue domestic debt in its own currency and sell it to foreigners. This is a major facet of economic power. One of the greatest benefits of being the issuer of a reserve currency, is the ability to have foreigners buy up debt denominated in your currency. The US is benefiting tremendously from the amount of debt around the world that is denominated in US dollars. The entire reason China is so delicately approaching the issue of reserve currency status, is all of the US dollars they accumulated over the past years were funneled into mostly USD-denominated debt. Now, they have just as much of an interest in preventing a sudden USD collapse as Obama & Co.

The flip side of this issue is the vulnerability of nations that do not issue debt in their own currency, an example being Argentina earlier this decade. After a period of hyperinflation in the 1980s, the government pegged its currency to the USD and issued billions of dollars of debt throughout the 90s. As their economy began to deteriorate rapidly from a combination of factors in 2001, investors began fleeing from the country’s assets. Government revenues and local trade were still executed in Argentine Peso, but the government needed to make interest payments on their debt in US Dollars. You now had a situation where the ability of the nation to pay out the interest on their debt is destroyed by the double-edged sword of a collapsing currency and collapsing revenue. That interest payment that was coming due was suddenly costing the government way more in Pesos than originally forecast, (note: the ARS was technically pegged to the USD so this pain is experienced through a variety of mechanisms) leading to Argentina eventually having to default on over 90bn USD of debt in 2001.

There are currently many examples of companies issuing debt in currencies other than their own. Corporations, especially of the multinational variety, often want to avoid fluctuations in their native countries local currency and instead look to base the issuance on a major currency. Some fairly hilarious names are borne of this practice, ranging from the fairly common Samurai bonds (non-Japanese entities issuing debt in Japanese Yen), to the Kangaroo Bond (Aussie Dollar denominated by non-Australian issuer in Australia), to the ubiquitous but less creatively named Eurodollar Bond (USD denominated by a non-US entity outside the US).

As the USD is still the world’s leading reserve currency and USD-denominated debt constitutes the vast majority of debt circulating (Eurodollar bonds are estimated to be nearly 80% of the international bond market), the announcement from China should be applauded. Moving away from the economic order where China’s consumption of USD and related assets allowed for excessive borrowing (concisely referred to as ‘Chimerica’ by Niall Fergson) in a careful manner should be the goal of economic policymakers globally. China’s effort to increase their currency’s presence in the world of debt is one key element of this healthy rebalancing.